1

NON PERFORMING ASSETS IN BANKS

REPORT SUBMITTED TO RAI BUSINESS SCHOOL IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE FOLLOWING AWARD OF

MBA

RUKHSANA YASMEEN E.NO. 06BBA03033 SEMESTER IV FINANCE & MARKETING JANUARY 2007

NON PERFORMING ASSETS IN BANKS

REPORT SUBMITTED TO RAI BUSINESS SCHOOL IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE FOLLOWING AWARD OF

MBA

RUKHSANA YASMEEN E.NO. 06BBA03033 SEMESTER IV FINANCE & MARKETING FEBRUARY 2007

CANDIDATE DECLARATION FORM

RUKHSANA YASMEEN, 06BBA030333

I hereby declare that the summer training report entitled NON PERFORMING
ASSETS IN BANKS submitted by me in partial fulfillment of the requirements for

the MBA, is my original work and that its has not been previously formed for the basis for the award of any other Degree, Diploma, Fellowship or any other similar titles.

Rukhsana Yasmeen

Place: - Delhi Date: 3rd FEB 2007

ACKNOWLEDGEMENT

The work with this dissertation has been extensive and trying, but in the first place exciting, instructive, and fun. Without help, support, and encouragement from several persons, I would never have been able to finish this work.

First of all, I would like to thank my teacher and guide Mr. S.P.Singh who not only served as my supervisor but also encouraged and challenged me throughout my academic program. He patiently guided me through the dissertation process, never accepting less than my best efforts. His editorial advice was essential to the completion of this dissertation and has taught me innumerable lessons and insights on the workings of academic research in general.

TABLE OF CONTENTS
S.NO. 1. 2. 3. 4. TOPIC DECLARATION FORM ACKNOWLEDGEMENT ABSTRACT INTRODUCTION What is NPA Basel norm I Evolution of NPAs PAGE NO. 3 4 6 8 12

5.

LITERATURE REVIEW Banking theory history and banking system Banking composition Banking today and tomorrow
COCEPTUAL ANALYSIS Indian banking system The problem of non performing assets Reasons for turning an asset in NPA Trend in NPAs FINDINGS AND CONCLUSIONS Impact of NPAs Difficulties with NPA Key structural changes Reporting format of NPA RECOMMENDATION

13- 33

6.

34 52

7.

53- 60

8.

61- 64 9. REFERENCES 65

ABSTRACT
This report deals with the problem of having non-performing assets, the reasons for mounting of non-performing assets and the practices present in country for dealing with non-performing assets.

Banks are in the business of managing risk, not avoiding it..

Risk is the fundamental element that drives financial behaviour. Without risk, the financial system would be vastly simplified. However, risk is omnipresent in the real world. Financial Institutions, therefore, should manage the risk efficiently to survive in this highly uncertain world. The future of banking will undoubtedly rest on risk management dynamics. Only those banks that have efficient risk management system will survive in the market in the long run. The effective management of credit risk is a critical component of comprehensive risk management essential for long-term success of a banking institution. Credit risk is the oldest and biggest risk that bank, by virtue of its very nature of business, inherits. This has however, acquired a greater significance in the recent past for various reasons. Foremost among them is the wind of economic liberalization that is blowing across the globe. India is no exception to this swing towards market driven economy. Better credit portfolio diversification enhances the prospects of the reduced concentration credit risk as empirically evidenced by direct relationship between concentration credit risk profile and NPAs of banks.

A banks success lies in its ability to assume and aggregate risk within tolerable and manageable limits.
Financial sector reform in India has progressed rapidly on aspects like interest rate deregulation, reduction in reserve requirements, barriers to entry, prudential norms and risk-based supervision. But progress on the structural-institutional aspects has been much slower and is a cause for concern. The sheltering of weak institutions while liberalizing operational rules of the game is making implementation of operational changes difficult and ineffective. Changes required to tackle the NPA problem would have to span the entire gamut of judiciary, polity and the bureaucracy to be truly effective. The future of Indian Banking represents a unique mixture of unlimited opportunities amidst insurmountable challenges. On the one hand we see the scenario represented by the rapid process of globalisation presently taking shape bringing the community of nations in the world together, transcending geographical boundaries, in the sphere of trade and commerce, and even employment opportunities of individuals. All these indicate newly emerging opportunities for Indian Banking. But on the darker side we see the accumulated morass, brought out by three decades of controlled and regimented management of the banks in the past. It has siphoned profitability of the Government owned banks, accumulated bloated NPA and threatens Capital Adequacy of the Banks and their continued stability. Nationalised banks are heavily over-staffed. The recruitment, training, placement and promotion policies of the banks leave much to be desired. In the nutshell the problem is how to shed the legacies of the past and adapt to the demands of the new age.

Chapter I

INTRODUCTION

INTRODUCTION
Banking sector reforms in India has progressed promptly on aspects like interest rate deregulation, reduction in statutory reserve requirements, prudential norms for interest rates, asset classification, income recognition and provisioning. But it could not match the pace with which it was expected to do. The accomplishment of these norms at the execution stages without restructuring the banking sector as such is creating havoc During pre-nationalization period and after independence, the banking sector remained in private hands Large industries who had their control in the management of the banks were utilizing major portion of financial resources of the banking system and as a result low priority was accorded to priority sectors. Government of India nationalized the banks to make them as an instrument of economic and social change and the mandate given to the banks was to expand their networks in rural areas and to give loans to priority sectors such as small scale industries, self-employed groups, agriculture and schemes involving women. To a certain extent the banking sector has achieved this mandate. Lead Bank Scheme enabled the banking system to expand its network in a planned way and make available banking series to the large number of population and touch every strata of society by extending credit to their productive endeavours. This is evident from the fact that population per office of commercial bank has come down from 66,000 in the year 1969 to 11,000 in 2004. Similarly, share of advances of public sector banks to priority sector increased form 14.6% in 1969 to 44% of the net bank credit. The number of deposit accounts of the banking system increased from over 3 crores in 1969 to over 30 crores. Borrowed accounts increased from 2.50 lakhs to over 2.68 crores. Non-performing assets, also called non-performing loans, are loans on which repayments or interest payments are not being made on time. A loan is an asset for a bank as the interest payments and the repayment of the principal create a stream of cash flows. It is from the interest payments than a bank makes its profits. Banks usually treat assets as non-performing if they are not serviced for some time. If payments are late for a short time a loan is classified as past due. Once a payment becomes really late (usually 90 days) the loan classified as non-performing. A high level of non-performing assets compared to similar lenders may be a sign of problems, as may a sudden increase. However this needs to be looked at in the context of the type of lending being done. Some banks lend to higher risk customers than others and therefore tend to have a higher proportion of non-performing debt, but will make up for this by charging borrowers higher interest rates, increasing spreads. A mortgage lender will almost certainly have lower non performing assets than a credit card specialist, but the latter will have higher spreads and may well make a bigger profit on the same assets, even if it eventually has to write off the non-performing loans.

9 Non Performing Asset means an asset or account of borrower, which has been classified by a bank or financial institution as sub-standard, doubtful or loss asset, in accordance with the directions or guidelines relating to asset classification issued by RBI. An amount due under any credit facility is treated as "past due" when it has not been paid within 30 days from the due date. Due to the improvement in the payment and settlement systems, recovery climate, upgradations of technology in the banking system, etc., it was decided to dispense with 'past due' concept, with effect from March 31, 2001. Accordingly, as from that date, a Non performing asset (NPA) shell be an advance where i. ii. iii. iv. interest and /or installment of principal remain overdue for a period of more than 180 days in respect of a Term Loan, the account remains 'out of order' for a period of more than 180 days, in respect of an overdraft/ cash Credit(OD/CC), the bill remains overdue for a period of more than 180 days in the case of bills purchased and discounted, interest and/ or installment of principal remains overdue for two harvest seasons but for a period not exceeding two half years in the case of an advance granted for agricultural purpose, and Any amount to be received remains overdue for a period of more than 180 days in respect of other accounts.

v.

With a view to moving towards international best practices and to ensure greater transparency, it has been decided to adopt the '90 days overdue' norm for identification of NPAs, form the year ending March 31, 2004. Accordingly, with effect form March 31, 2004, a non-performing asset (NPA) shell be a loan or an advance where; i. ii. iii. iv. interest and /or installment of principal remain overdue for a period of more than 90 days in respect of a Term Loan, the account remains 'out of order' for a period of more than 90 days, in respect of an overdraft/ cash Credit(OD/CC), the bill remains overdue for a period of more than 90 days in the case of bills purchased and discounted, interest and/ or installment of principal remains overdue for two harvest seasons but for a period not exceeding two half years in the case of an advance granted for agricultural purpose, and Any amount to be received remains overdue for a period of more than 90 days in respect of other accounts.

v.

Indian banks (particularly nationalised banks) are struggling to come out of the net of nonperforming assets. The rising level of non-performing assets (NPAs) amounting to about Rs 600 bn

10 has plagued the Indian banking system. Thus urgent cleaning up of bank balance sheet has become a crucial issue. Banks are in the risk business. In the process of providing financial services, they assume various kinds of risks viz. credit risk, market risk, operational risk, interest risk, forex risk and country risk. Among these different types of risks, credit constitutes the most dominant asset in the balance sheet, accounting for about 60% of total assets. The credit risk is generally made up of transaction risk (default risk) and portfolio risk. The risk management is a complex function and requires specialized skills and expertise. As a result managing credit risk efficiently assumes greater significance.

WHAT IS CALLED NPA?

It is those assets for which interest is overdue for more than 180 days. In simple words, an asset (or a credit facility) becomes non-performing when it ceases to yield income. As a result, banks do not recognize interest income on these assets unless it is actually received. If interest amount is already credited on an accrual basis in the past years, it should be reversed in the current years account if such interest is still remaining uncollected. Once an asset falls under the NPA category, banks are required by the Reserve Bank of India (RBI) to make provision for the uncollected interest on these assets. For the purpose they have to classify their assets based on the strength and on collateral securities into:

Standard assets: This is not a non-performing asset. It does not carry more than normal risk attached to the business. Substandard assets: It is an asset, which has been classified as non-performing for a period of less than two years. In this case the current networth of the borrower or the current market value of the security is not enough to ensure recovery of the debt due to the bank. The classification of substandard assets should not be upgraded (to standard assets) merely as a result of rescheduling of the payments. (Rescheduling indicates change in payment schedule by the borrower or by the banker) There must be a satisfactory performance for two years after such rescheduling. Doubtful assets: It is an asset, which has remained non-performing for a period exceeding two years. Loss assets: It is an asset identified by the bank, auditors or by the RBI inspection as a loss asset. It is an asset for which no security is available or there is considerable erosion in the realizable value of the security. (If the realizable value of the security as assessed by bank, approved valuers or RBI is less than 10% of the outstanding, it is known as considerable erosion in the value of asset.) As a result even though there may be some salvage or recovery value, its continuance as bankable asset is not warranted.

After classifying assets into above categories, banks are required to make provision against these assets for the interest not collected by them. In terms of exact prudential regulations, the provisioning norms are as under:

11 Asset Classification Provision requirements Standard assets Substandard assets Doubtful assets Loss assets 0.25% 10% 20% - 50% of the secured portion depending on the age of NPA, and 100% of the unsecured portion. It may be either written off or fully provided by the bank.

The increasing levels of bad quality loans marred the prospects of nationalised banks in the past few years. As a result banks shifted their focus from the industrial segment to the corporate lending. This has curtailed the incremental NPAs to a certain extent. The norms are tightened even for financial institutions (FIs). They are worst affected by the NPA wave thanks to lending to the commodity and economy sensitive sectors, not to mention that loans to steel, chemicals and textile sector played a key role in dragging down performance of FIs. So far they have been enjoying the privilege of recognizing a loan as NPA only if principal is overdue for more than 365 days and interest is outstanding for over 180 days. With a view to bring greater transparency, the RBI has proposed to reduce the time limit to 180 days (for principal). On the one hand imposition of stricter norms could lead to a difficult time for FIs, permitting them an option of restructuring their loans could give them some leeway. Apart from this scheme, the government has designed major policy reforms in order to enhance the efficiency of the banking system. It has decided to set up 7 more debt recovery tribunals (DRTs) in addition to the existing 22 and 5 appellate tribunals. It has also proposed to bring in legislation for facilitating foreclosure and enforcement of securities in case of default. Repealment of SICA (Sick Industrial Companies Act) was another major step. The RBI has already asked banks to file criminal cases against borrowers who are willful defaulters. These initiatives are expected to aid banks to quickly recover their dues from the borrowers.

Basel I Norms
Basel Committee is a committee of central banks and bank supervisors/ regulators from the major industrialized countries that meets every three months at the Bank for International Settlements in Basel. The Basel Committee consists of senior supervisory representatives from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Sweden, Switzerland, United Kingdom and the United States. Basel I was an attempt to standardise the regulation governing the global banking industry. It provides broad policy guidelines for banks that each country's supervisors can use to determine the supervisory policies they apply. The proposed New Basel Capital Accord is to be built on three mutually reinforcing pillars: o Minimum capital requirements o Supervisory review process

12 o Market discipline EVOLUTION OF NPAs In the early Nineties PSBs were suffering from acute capital inadequacy and many of them were depicting negative profitability. This is because the parameters set for their functioning were deficient and they did not project the paramount need for these corporate goals. Incorrect goal perception and identification led them to wrong destination Since the 70s, the SCBs of India functioned totally as captive capsule units cut off from international banking and unable to participate in the structural transformations, the sweeping changes, and the new type of lending products emerging in the global banking Institutions. The personnel lacked desired training and knowledge resources required to compete with international players. Such and other chaotic conditions in parts of the Indian Banking industry had resulted in the accumulation of assets, which were termed as non-productive in an unprecedented level "Audit and Inspections" remained as functions under the control of the executive officers, which were not independent and were thus unable to correct the effect of serious flaws in policies and directions of the higher ups. The quantum of credit extended by the PSBs increased by about 160 times in the three decades after nationalization (from around Rs. 3000 crore in 1970 to Rs. 475113 Crore in 2004). The Banks were not developed in terms of skills and expertise to regulate such stupendous growth in the volume and manage the diverse risks that emerged in the process. The need for organizing an effective mechanism to gather and disseminate credit information amongst the commercial banks was never felt or implemented. The archaic laws of secrecy of customers-information that was binding Bankers in India, disabled banks to publish names of defaulters for common knowledge of the other Banks in the system. Lack of effective corporate management Credit management on the part of the lenders to the borrowers to secure their genuine and bonafide interests was not based on pragmatically calculated anticipated cash flows of the borrower concern, while recovery of installments of Term Loans was not out of profits and surplus generated but through recourse to the corpus of working capital of the borrowing concerns. This eventually led to the failure of the project financed leaving idle assets. Functional inefficiency was also caused due to over-staffing, manual processing of over expanded operations and failure to computerize Banks in India, when elsewhere throughout the world the system was to switch over to computerization of operations.

13

Chapter II

LITERATURE REVIEW

14

BANKING- THEORY & PRACTICE - HISTORY & EVOLUTION OF INDIAN BANKING SYSTEM
"India's banking system has several outstanding achievements to its credit, the most striking of which is its reach. An extensive banking network has been established in the last thirty years, and India's banking system is no longer confined to metropolitan cities and large towns: in fact, Indian banks are now spread out into the remote corners of our country. In terms of the number of branches, India's banking system is one of the largest, if not the largest in the world today. An even more significant achievement is the close association of India's banking system with India's development efforts. The diversification and development of our economy, and the acceleration of the growth process, are in no small measure due to the active role that banks have played in financing economic activities in different sectors." [ Dr.Bimal Jalan, Governor RBI in a speech delivered at the 22nd Bank Economists' Conference, New Delhi,15th February, 2001 ] WE CAN IDENTIFY THREE DISTINCT PHASES IN THE HISTORY OF INDIAN BANKING. 1. Early phase from 1786 to 1969 2. Nationalisation of Banks and up to 1991 prior to banking sector Reforms 3. New phase of Indian Banking with the advent of Financial & Banking Sector Reforms after 1991. The first phase is from 1786 to 1969, the early phase up to the nationalisation of the fourteen largest of Indian scheduled banks. It was also the traditional or conservative phase of Indian Banking. The advent of banking system of India started with the establishment of the first joint stock bank, The General Bank of India in the year 1786. After this first bank, Bank of Hindustan and Bengal Bank came to existence. In the mid of 19th century, East India Company established three banks The Bank of Bengal in 1809, The Bank of Bombay in 1840, and bank of Madras in 1843. These banks were independent units and called Presidency banks. These three banks were amalgamated in 1920 and a new bank, Imperial Bank of India was established. All these institutions started as private shareholders banks and the shareholders were mostly Europeans. The Allahabad Bank was established in 1865. The next bank to be set up was the Punjab National Bank Ltd. which was established with its headquarters at Lahore in 1894 for the first time exclusively by Indians. Most of the Indian commercial banks, however, owe their origin to the 20th century. Bank of India, Central Bank of India, Bank of Baroda, the Canara Bank, the Indian Bank, and the Bank of Mysore were established between 1906 and 1913. The last major commercial bank to be set up in this phase was the United Commercial Bank in 1943. Earlier the establishment of Reserve Bank of India in 1935 as the central bank of the country was an important step in the development of commercial banking in India. The history of joint stock banking in this first phase was characterised by slow growth and periodic failures. There were as many as 1100 banks, mostly small banks, failed during the period from

15 1913 to 1948. The Government of India concerned by the frequent bank failures in the country causing miseries to innumerable small depositors and others enacted The Banking Companies Act, 1949. The title of the Act was changed as "Banking Regulation Act 1949", as per amending Act of 1965 (Act No.23 of 1965). The Act is the first regulatory step undertaken by the Government to streamline the functioning and activities of commercial banks in India. Reserve Bank of India as the Central Banking Authority of the country was vested with extensive powers for banking supervision. Salient features of the Act are discussed in a separate page/article At the time of Independence of the country in 1947, the banking secor in India was relatively small and extremely weak. The banks were largely confined to urban areas, extending loans primarily to trading sector dealing with agricultural produce. There were a large number of commercial banks, but banking services were not available at rural and semi-urban areas. Such services were not extended to different sectors of the economy like agriculture, small industries, professionals and self-employed entrepreneurs, artisans, retail traders etc. DEFICIENCIES OF INDIAN BANKING SYSTEM BEFORE NATIONALISATION Commercial banks, as they were privately owned, on regional or sectarian basis resulted in development of banking on ethnic and provincial basis with parochial outlook. These Institutions did not play their due role in the planned development of the country. Deposit mobilisation was slow. Public had less confidence in the banks on account of frequent bank failures. The savings bank facility provided by the Postal department was viewed a comparatively safer field of investment of savings by the public. Even the deficient savings thus mobilised by commercial banks were not channeled for the development of the economy of the country. Funds were largely given to traders, who hoarded agricultural produce after harvest, creating an artificial scarcity, to make a good fortune in selling them at a later period, when prices were soaring. The Reserve Bank of India had to step in at these occasions to introduce selective credit controls on several commodities to remedy this situation. Such controls were imposed on advances against Rice, Paddy, Wheat, Other foodgrains (like jowar, millets, ragi etc.) pulses, oilseeds etc. INITIAL PHASE OF NATIONALISATION When the country attained independence Indian Banking was exclusively in the private sector. In addition to the Imperial Bank, there were five big banks each holding public deposits aggregating Rs.100 Crores and more, viz. the Central Bank of India Ltd., the Punjab National Bank Ltd., the Bank of India Ltd., the Bank of Baroda Ltd. and the United Commercial Bank Ltd. Rest of the banks were exclusively regional in character holding deposits of less than Rs.50 Crores. Government first implemented the exercise of nationalisation of a significant part of the Indian Banking system in the year 1955, when Imperial Bank of India was Nationalised in that year for the stated objective of "extension of banking facilities on a large scale, more particularly in the rural and semi-urban areas, and for diverse other public purposes" to form State Bank of India. SBI was to act as the principal agent of the RBI and handle banking transactions of the Union & State Governments throughout India. The step was in fact in furtherance of the objectives of supporting a powerful rural credit cooperative movement in India and as recommended by the "The All-India Rural Credit Survey Committee Report, 1954". State Bank of India was obliged to open an

16 accepted number of branches within 5 years in unbanked centres. Government subsidised the bank for opening unremunerative branches in non-urban centres. The seven banks now forming subsidiaries of SBI were nationalised in the year 1960. This brought one-third of the banking segment under the direct control of the Government of India. But the major process of nationalisation was carried out on 19th July 1969, when the then Prime Minister of India, Mrs.Indira Gandhi announced the nationalisation of 14 major commercial banks in the country. One more phase of nationalisation was carried out in the year 1980, when seven more banks were nationalised. This brought 80% of the banking segment in India under Government ownership. The country entered the second phase, i.e. the phase of Nationalised Banking with emphasis on Social Banking in 1969/70. CHRONOLOGY OF SALIENT STEPS BY THE GOVERNMENT AFTER INDEPENDENCE TO REGULATE BANKING INSTITUTIONS IN THE COUNTRY 1. 2. 3. 4. 5. 6. 7. 8. 1949 : Enactment of Banking Regulation Act. 1955(Phase I) : Nationalisation of State Bank of India 1959(Phase II) : Nationalisation of SBI subsidiaries 1961 : Insurance cover extended to deposits 1969(Phase III) : Nationalisation of 14 major banks 1971 : Creation of credit guarantee corporation 1975 : Creation of regional rural banks 1980(Phase IV) : Nationalisation of seven banks with deposits over 200 crores.

ASSESSMENT OF POSITIVE RESULTS OF THE STEPS TAKEN BY GOVERNMENT AFTER INDEPENDENCE The government's banking policy has paid rich dividends over the last three decades in terms of the objectives set up, after 1969 when 14 major private banks were nationalised. Apart from the nationalisation process, the other features of the policy include enactment of the Banking Regulation Act in 1949, and the creation of the first state-owned State Bank of India in 1955. The policy has resulted in the creation of the massive network of the banking structure in the country. The major chunk of the structure was contributed by the nationalised banks, which number 27 at present. According to bank economists, during the last 28 years of nationalisation, the branches of the public sector banks rose 800 per cent from 7,219 to 57,000, with deposits and advances taking a huge jump by 11,000 per cent and 9,000 per cent to Rs 5,035.96 billion and Rs 2,765.3 billion respectively.(statistics as at 1993) Contrary to the popular belief, employee productivity has been rising in the nationalised banks over the period, as per studies conducted by economists. Productivity per employee in respect of business volume (both deposits and advances) has gone up from Rs 250,000 in 1969 to Rs 4,780,000 in 1993. Accordingly, profits of these banks went up to Rs 30 billion in 1993 as against Rs 90 million at the time of the nationalisation. These banks also contributed to the generation of employment. Their staff strength increased by 300 per cent over the period to 900,000. The growth

17 of the banking sector after the nationalisation was unprecedented anywhere in the world. It is particularly true of branch expansion to every nook and corner of the country. While there were hardly any branch in the rural areas in 1969, 35,000 bank branches are operating there at present (1993). SHORTCOMINGS INSTITUTIONS IN THE FUNCTIONING OF NATIONALISED BANKING

However Nationalised banks in their enthusiasm for development banking, looking exclusively to branch opening, deposit accretion and social banking, neglected prudential norms, profitability criteria, risk-management and building adequate capital as a buffer to counter-balance the ever expanding risk-inherent assets held by them. They failed to recognise the emerging nonperforming assets and to build adequate provisions to neutralise the adverse effects of such assets. Basking in the sunshine of Government ownership that gave to the public implicit faith and confidence about the sustainability of Government-owned institutions, they failed to collect before hand whatever is needed for the rainy day. And surfeit blindly indulged is sure to bring the sick hour. In the early Nineties after two decades of lop-sided policies, these banks paid heavily for their misdirected performance in place of pragmatic and balanced policies. The RBI/Government of India has to step in at the crisis-hour to implement remedial steps. Reforms in the financial and banking sectors and liberal recapitalisation of the ailing and weakened public sector banks followed. The emphasis shifted to efficient, and prudential banking linked to better customer care and customer service. The old ideology of social banking was not abandoned, but the responsibility for development banking is blended with the paramount need for complying with norms of prudency and efficiency.

COMPOSITION OF INDIAN BANKING SYSTEM

INDIAN BANKING SYSTEM The banking system has three tiers. These are the scheduled commercial banks; the regional rural banks which operate in rural areas not covered by the scheduled banks; and the cooperative and special purpose rural banks. SCHEDULED AND NON SCHEDULED BANKS

There are approximately 80 scheduled commercial banks, Indian and foreign; almost 200 regional rural banks; more than 350 central cooperative banks, 20 land development banks; and a number of primary agricultural credit societies. In terms of business, the public sector banks, namely the State Bank of India and the nationalized banks, dominate the banking sector.

18 India had a fairly well developed commercial banking system in existence at the time of independence in 1947. The Reserve Bank of India (RBI) was established in 1935. While the RBI became a state owned institution from January 1, 1949, the Banking Regulation Act was enacted in 1949 providing a framework for regulation and supervision of commercial banking activity. The first step towards the nationalisation of commercial banks was the result of a report (under the aegis of RBI) by the Committee of Direction of All India Rural Credit Survey (1951) which till today is the locus classicus on the subject. The Committee recommended one strong integrated state partnered commercial banking institution to stimulate banking development in general and rural credit in particular. Thus, the Imperial Bank was taken over by the Government and renamed as the State Bank of India (SBI) on July 1, 1955 with the RBI acquiring overriding substantial holding of shares. A number of erstwhile banks owned by princely states were made subsidiaries of SBI in 1959. Thus, the beginning of the Plan era also saw the emergence of public ownership of one of the most prominent of the commercial banks. The All-India Rural Credit Survey Committee Report, 1954 recommended an integrated approach to cooperative credit and emphasised the need for viable credit cooperative societies by expanding their area of operation, encouraging rural savings and diversifying business. The Committee also recommended for Government participation in the share capital of the cooperatives. The report subsequently paved the way for the present structure and composition of the Cooperative Banks in the country There was a feeling that though the Indian banking system had made considerable progress in the '50s and '60s, it established close links between commercial and industry houses, resulting in cornering of bank credit by these segments to the exclusion of agriculture and small industries. To meet these concerns, in 1967, the Government introduced the concept of social control in the banking industry. The scheme of social control was aimed at bringing some changes in the management and distribution of credit by the commercial banks. The close link between big business houses and big banks was intended to be snapped or at least made ineffective by the reconstitution of the Board of Directors to the effect that 51 per cent of the directors were to have special knowledge or practical experience. Appointment of whole-time Chairman with special knowledge and practical experience of working of commercial banks or financial or economic or business administration was intended to professionalise the top management. Imposition of restrictions on loans to be granted to the directors' concerns was another step towards avoiding undesirable flow of credit to the units in which the directors were interested. The scheme also provided for the take-over of banks under certain circumstances. Political compulsion then partially attributed to inadequacies of the social control, led to the Government of India nationalising, in 1969, 14 major scheduled commercial banks which had deposits above a cut-off size. The objective was to serve better the needs of development of the economy in conformity with national priorities and objectives. In a somewhat repeat of the same experience, eleven years after nationalisation, the Government announced the nationalisation of seven more scheduled commercial banks above the cut-off size. The second round of nationalisation gave an impression that if a private sector bank grew to the cut-off size it would be under the threat of nationalisation.

19 From the fifties a number of exclusively state-owned development financial institutions (DFIs) were also set up both at the national and state level, with a lone exception of Industrial Credit and Investment Corporation (ICICI) which had a minority private share holding. The mutual fund activity was also a virtual monopoly of Government owned institution, viz., the Unit Trust of India. Refinance institutions in agriculture and industry sectors were also developed, similar in nature to the DFIs. Insurance, both Life and General, also became state monopolies. Reform Measures The major challenge of the reform has been to introduce elements of market incentive as a dominant factor gradually replacing the administratively coordinated planned actions for development. Such a paradigm shift has several dimensions, the corporate governance being one of the important elements. The evolution of corporate governance in banks, particularly, in PSBs, thus reflects changes in monetary policy, regulatory environment, and structural transformations and to some extent, on the character of the self-regulatory organizations functioning in the financial sector. Policy Environment During the reform period, the policy environment enhanced competition and provided greater opportunity for exercise of what may be called genuine corporate element in each bank to replace the elements of coordinated actions of all entities as a "joint family" to fulfill predetermined Plan priorities. Greater competition has been infused in the banking system by permitting entry of private sector banks (9 licences since 1993), and liberal licensing of more branches by foreign banks and the entry of new foreign banks. With the development of a multi-institutional structure in the financial sector, emphasis is on efficiency through competition irrespective of ownership. Since non-bank intermediation has increased, banks have had to improve efficiency to ensure survival. Regulatory Environment Prudential regulation and supervision have formed a critical component of the financial sector reform programme since its inception, and India has endeavoured to international prudential norms and practices. These norms have been progressively tightened over the years, particularly against the backdrop of the Asian crisis. Bank exposures to sensitive sectors such as equity and real estate have been curtailed. The Banking Regulation Act 1949 prevents connected lending (i.e. lending by banks to directors or companies in which Directors are interested). Periodical inspection of banks has been the main instrument of supervision, though recently there has been a move toward supplementary 'on-site inspections' with 'off-site surveillance'. The system of 'Annual Financial Inspection' was introduced in 1992, in place of the earlier system of Annual Financial Review/Financial Inspections. The inspection objectives and procedures, have been redefined to evaluate the bank's safety and soundness; to appraise the quality of the Board and management; to ensure compliance with banking laws & regulation; to provide an appraisal of soundness of the bank's assets; to analyse the financial factors which determine bank's solvency and to identify areas where corrective action is needed to strengthen the institution and improve its performance. Inspection based upon the new guidelines have started since 1997.

20 Self Regulatory Organizations India has had the distinction of experimenting with Self Regulatory Organisations (SROs) in the financial system since the pre-independence days. At present, there are four SROs in the financial system 1. 2. 3. 4. Indian Banks Association (IBA), Foreign Exchange Dealers Association of India (FEDAI), Primary Dealers Association of India (PDAI) and Fixed Income Money Market Dealers Association of India (FIMMDAI). Indian Banks Association

The IBA established in 1946 as a voluntary association of banks, strove towards strengthening the banking industry through consensus and co-ordination. Since nationalisation of banks, PSBs tended to dominate IBA and developed close links with Government and RBI. Often, the reactive and consensus and coordinated approach bordered on cartelisation. To illustrate, IBA had worked out a schedule of benchmark service charges for the services rendered by member banks, which were not mandatory in nature, but were being adopted by all banks. The practice of fixing rates for services of banks was consistent with a regime of administered interest rates but not consistent with the principle of competition. Hence, the IBA was directed by the RBI to desist from working out a schedule of benchmark service charges for the services rendered by member banks. Responding to the imperatives caused by the changing scenario in the reform era, the IBA has, over the years, refocused its vision, redefined its role, and modified its operational modalities. Foreign Exchange Dealers Association of India (FEDAI)

In the area of foreign exchange, FEDAI was established in 1958, and banks were required to abide by terms and conditions prescribed by FEDAI for transacting foreign exchange business. In the light of reforms, FEDAI has refocused its role by giving up fixing of rates, but plays a multifarious role covering training of banks' personnel, accounting standards, evolving risk measurement models like the VaR and accrediting foreign exchange brokers. SROs Regulating Financial Markets

In the financial markets, the two SROs, viz., the PDAI and the FIMMDAI are of recent origin i.e. 1996 and 1997. These two SROs have been proactive and are closely involved in contemporary issues relating to development of money and government securities markets. The representatives of PDAI and FIMMDAI are members of important committees of the RBI, both on policy and operational issues. To illustrate, the Chairmen of PDAI and FIMMDAI are members of the Technical Advisory Group on Money and Government Securities market of the RBI. These two SROs have been very proactive in mounting the technological infrastructure in the money and Government Securities markets. The FIMMDAI has now taken over the responsibility of publishing the yield curve in the debt markets. Currently, the FIMMDAI is working towards development of uniform documentation and accounting principles in the repo market. Composition of the Banking System as at the Beginning of New Millennium

21 At present the number of nationalised banks are 20. Several Foreign banks were allowed to operate as per the guidelines of RBI. At present the banking system can be classified in following categories: PUBLIC SECTOR BANKS

Reserve Bank of India State Bank of India and its 7 associate Banks Nationalised Banks (20 in number) Regional Rural Banks sponsored by Public sector Banks

PRIVATE SECTOR BANKS

Old Generation Private Banks New Generation Private Banks Foreign Banks in India Scheduled Co-operative Banks Non Scheduled Banks

CO-OPERATIVE SECTOR BANKS

State Co-operative Banks Central Co-operative Banks Primary agriculture Credit Societies Land Development Banks Urban Co-operative Banks State Land Development Banks

DEVELOPMENT BANKS

Industrial Finance Corporation of India (IFCI) Industrial Development bank of India (IDBI) Industrial Credit & Investment corporation of India (ICICI) Industrial Investment Bank of India (IIBI) Small Industries Development Bank of India (SIDBI) National Bank for Agriculture & Rural Development (NABARD) Export-Import Bank of India

BANKING REGULATION ACT, 1949 The Banking Regulation Act enacted in 1949 provides a framework for regulation and supervision of commercial banking activity. The provisions of this Act shall be in addition to, and not, in

22 derogation of the Companies Act, 1956 (1 of 1956), and any other law for the time being in force. However the provisions of the Companies Act applies to only the banks in the private sector. Provisions of the Act does not apply toa. a primary agricultural credit society; b. a co-operative land mortgage bank; and c. Any other co-operative society, except in certain cases. Definition of Banking Business Banking as defined in the Section 5 (b) of the Banking Regulations Act, 1949 is the business of "Accepting deposits of money from the public for the purpose of lending or investment". These deposits are repayable on demand or otherwise, and withdrawable by a cheque, draft, order or otherwise. The deposits accepted by Banking Company are different from those accepted by Non Banking Finance Company or any other company in the nature in which these are repayable. Banks are the only financial institutes which can accept demand deposits (Saving / Current) which can be withdrawn by a cheque. Section 6 of Banking Regulations Act, 1949 elaborately specifies the other forms of business which a banking company may carry in addition to banking as defined in section 5. These include in a nutshell

Issuing Demand Drafts & Travellers Cheques Collection of Cheques, Bills of exchange Discounting and purchase of Bills Safe Deposit Lockers Issuing Letters of Credit & Letters of Guarantee Sales and Purchase of Foreign Exchange Custodial Services Investment services doing all such other things as are incidental or conducive to the promotion or advancement of the business of the company; Any other form of business which the Central Government may, by notification in the Official Gazette, specify as a form of business in which it is lawful for a banking company to engage.

No banking company shall engage in any form of business other than those referred to above Use of words "bank", "banker", "banking" or "banking company" No company other than a banking company shall use as part of its name or, in connection with its business any of the words "bank", "banker" or "banking" and no company shall carry on the business of banking in India unless it uses as part of its name at least one of such words. No firm,

23 individual or group of individuals shall, for the purpose of carrying on any business, use as part of its or his name any of the words "bank", "banking" or "banking company". However the following bodies are exempted from the above restriction to the extent specified. a. a subsidiary of a banking company formed for one or more of the purposes mentioned in sub-section (1) of section 19, whose name indicates that it is a subsidiary of that banking company; b. Any association of banks formed for the protection of their mutual interests and registered under section 25 of the Companies Act, 1956 (1 of 1956). Prohibition of Trading No banking company shall directly or indirectly deal in the buying or selling or bartering of goods, except in connection with the realization of security given to or held by it, or engage in any trade, or buy, sell or barter goods for others otherwise than in connection with bills of exchange received for collection or negotiation or with such of its business. However this restriction shall not apply in respect of those functions or any other form of business which the Central Government may, by notification in the Official Gazette, specify as a form of business in which it is lawful for a banking company to engage. Explanation: For the purposes of this section, "goods" means every kind of movable property, other than actionable claims, stock, shares, money, bullion and specie and all instruments referred to in clause (a) of sub-section (1) of section 6. The aforesaid clause reads as under: "drawing, making, accepting, discounting, buying, selling, collecting and dealing in bills of exchange, hundies, promissory notes, coupons, drafts, bill of lading, railway receipts, warrants, debentures, certificates, scrips and other instruments, and securities whether transferable or negotiable or not; the granting and issuing of letters of credit, travellers' Cheques and circular notes; the buying, selling and dealing in bullion and specie; the buying and selling of foreign exchange including foreign bank notes; the acquiring, holding, issuing on commission, underwriting and dealing in stock, funds, shares, debentures, debenture stock, bonds, obligations, securities and investments of all kinds; the purchasing and selling of bonds, scrips or other forms of securities on behalf of constituents or others; the negotiating of loan and advances; the receiving of all kinds of bonds, scrips or valuables on deposit or for safe custody or otherwise; the providing of safe deposit vaults; the collecting and transmitting of money and securities;"

Disposal of Non-Banking Assets No banking company shall hold any immovable property howsoever acquired, except such as is required for its own use, for any period exceeding seven years from the acquisition thereof or from the commencement of this Act, whichever is later or any extension of such period as in this section

24 provided, and such property shall be disposed of within such period or extended period, as the case may be: PROVIDED that the banking company may, within the period of seven years as aforesaid, deal or trade in any such property for the purpose of facilitating the disposal thereof: PROVIDED FURTHER that the Reserve Bank may in any particular case extend the aforesaid period of seven years by such period not exceeding five years where it is satisfied that such extension would be in the interests of the depositors of the banking company.

INDIAN BANKING TODAY & TOMORROW

25 The future of Indian Banking represents a unique mixture of unlimited opportunities amidst insurmountable challenges. On the one hand we see the scenario represented by the rapid process of globalisation presently taking shape bringing the community of nations in the world together, transcending geographical boundaries, in the sphere of trade and commerce, and even employment opportunities of individuals. All these indicate newly emerging opportunities for Indian Banking. But on the darker side we see the accumulated morass, brought out by three decades of controlled and regimented management of the banks in the past. It has siphoned profitability of the Government owned banks, accumulated bloated NPA and threatens Capital Adequacy of the Banks and their continued stability. Nationalised banks are heavily over-staffed. The recruitment, training, placement and promotion policies of the banks leave much to be desired. In the nutshell the problem is how to shed the legacies of the past and adopt to the demands of the new age. On the brighter side are the opportunities on account of 1. The advent of economic reforms, the deregulation and opening of the Indian economy to the global market, brings opportunities over a vast and unlimited market to business and industry in our country, which directly brings added opportunities to the banks. 2. The advent of Reforms in the Financial & Banking Sectors (the first phase in the year 1992 to 1995) and the second phase in 1998 heralds a new welcome development to reshape and reorganise banking institutions to look forward to the future with competence and confidence. The complete freeing of Nationalised Banks (the major segment) from administered policies and Government regulation in matters of day to day functioning heralds a new era of self-governance and a scope for exercise of self initiative for these banks. There will be no more directed lending, pre-ordered interest rates, or investment guidelines as per dictates of the Government or RBI. Banks are to be managed by themselves, as independent corporate organizations, and not as extensions of government departments. 3. Acceptance of prudential norms with regards to Capital Adequacy, Income Recognition and Provisioning are welcome measures of self regulation intended to fine-tune growth and development of the banks. It introduces a new transparency, and the balance sheets of banks now convey both their strength and weakness. Capital Adequacy and provisioning norms are intended to provide stability to the Banks and protect them in times of crisis. These equally induce a measure of corporate accountability and responsibility for good management on the part of the banks 4. Large scale switching to hi-tech banking by Indian Scheduled Commercial Banks(SCBs) through the application of Information Technology and computerisation of banking operations, will revolutionalise customer service. The age-old method of 'pen and ink' systems are over. Banks now will have more employees available for business development and customer service freed from the needs of book-keeping and for casting or tallying balances, as it was earlier. All these welcome changes towards competitive and constructive banking could not however, deliver quick benefits on account insurmountable carried over problems of the past three decades. Since the 70s the SCBs of India functioned totally as captive capsule units cut off from international banking and unable to participate in the structural transformations, the sweeping changes, and the new type of lending products emerging in the global banking Institutions. Our

26 banks are over-staffed. The personnel lack training and knowledge resources required to compete with international players. The prevalence of corruption in public services of which PSBs are an integral part and the chaotic conditions in parts of the Indian Industry have resulted in the accumulation of non-productive assets in an unprecedented level. The future of Indian Banking is dependent on the success of its efforts as to how it shakes off these accumulated past legacies and carried forward ailments and how it regenerates itself to avail the new vistas of opportunities to be able to turn Indian Banking to International Standards. PSBs in India can solve their problems only if they assert a spirit of self-initiative and self-reliance through developing their in-house expertise. They have to imbibe the banking philosophy inherent in de-regulation. They are free to choose their respective paths and set their independent goals and corporate mission. The first need is management upgradation. We have learnt prudential norms of asset classification and provisioning. More important now, we must learn prudential norms of asset creation, of credit assessment and credit delivery, of risk forecasting and de-risking strategies. The habit of looking to RBI and Government of India to step in and remove the barriers in the way of the Banks should be given a go-bye. NPA is a problem created by the Banks and they have to find the cause and the solution - how it was created and how the Banks are to overcome it. Powerful Institutions can be nurtured by strong and dynamic management and not by corrupt and weak bureaucrats. These issues are discussed with frankness and candour in these pages, under titles listed in the Table of Contents(see Menu Bar at the top), which provide you a direct access to any or all the topics of your choice. Public sector ownership need not result in inefficiency and poor customer service. These are not due to the ills of ownership, but due to failure to accept the correct "Mission" and "Goals" of management. On the other hand unlike several private sector units, Public sector units have specific plus points. They do not evade taxes, and do not accumulate unassessed wealth or unaccounted money. They do not bribe controlling persons to get their way through. They do not indulge in predatory "take over" of weaker rival units. In fact a public unit never competes unethically with its rival-units. Before the Sixties, banks in India were mainly lending to traders in agricultural commodities and conventional agro-based industries, like textiles, Rice & Oil Mills, Cotton Ginning factories etc. Indian Bankers actively entered the field of industrial finance from the mid-Sixties, when a number of industrial projects were promoted as a result of the then ongoing process of development planning in India. Industry was State controlled and State-protected from foreign competition through the barrier of high walls of import tariffs. In an age of high inflation with huge money supply, the demand for goods was always surging. Protection and lack of competition enabled Industry to face little risks. Thumb rules for financing Term Loans and Working Capital through memorized norms enabled Bankers to manage credit assessment, delivery and monitoring, facing no more than normal risks. However after the Eighties the position underwent a total transformation. The rupee was devalued in the early seventies and Government had to seek massive assistance from the IMF and World Bank and as per their prescription economic policies started progressively changing. Government Controls were being withdrawn gradually. But farreaching economic reforms were brought about only in the years 1991 and there after. In the year 1990-91 balance of payments position facing the country became critical and foreign exchange reserves had been depleted to dangerously low levels. Imports had to be severely curtailed in the

27 course 1990-91 because of shortage of foreign exchange. Importers were asked to deposit an amount equal to 200% of the L.C value with Banks in advance to be eligible for getting the L.Cs opened. This affected the availability of many essential items and also led to distinct slow down of industrial growth. The then urgent need of the hour was assessed as under: 1. To aim at quick revival of the momentum of exports. 2. To create strong incentives to economise on imports, without resorting to proliferation of licensing controls, which promote delay and inefficiency, generate arbitrariness and stifle enterprise. 3. There was urgent need to create an environment free from bureaucratic controls in which our exporters will be able to respond with speed and flexibility to changing international conditions. 4. To recognise the change that is taking place in the world economy, where countries are shedding isolation and getting increasingly integrated, and to shape our economic policies as part of the prevailing global environment. How Convertibility Was Achieved Through "LERMS"? LERMS representing Liberalised Exchange Management System was introduced in the year 1992 as part of a package of reforms intended to secure instant and permanent remedies for the problems ailing the Indian economy at that time. Some of the problems facing the country at that timer were as under:1. The balance of payments position facing the country had become critical and foreign exchange reserves had depleted to dangerously low levels i.e. $585 million, which was sufficient for financing just one week of India's exports. 2. Export momentum built during 1986-87 to 1989-90 was lost and exports decelerated to 9% in U.S. Dollars 3. Imports had to be severely curbed in 1990-91 because of shortage of foreign exchange. This affected the availability of many essential items and also led to a distinct slow down in industrial growth. 4. Inflation was rocking the country and fiscal deficit was going uncontrolled, resulting domestic prices unfavourable for export promotion. 5. The system of administered exchange allocations and rate fixation gave rise to parallel markets in foreign exchange, trade mis-invoicing and capital flights. Persons who required foreign exchange were unable to get the same under the regulations in force, but had recourse to the 'hawala' markets and brought the required foreign exchange at premium rates 6. Exporters under-invoiced their export earnings and moved away foreign exchange abroad or repatriated the same at a premium through the hawala route. There was considerable leakage of accruals in foreign exchange earnings due to NRI remittances being routed through these markets.

28 7. The unauthorised market also acted as conduits for financing smuggling operations into and out of the country. The black market for foreign exchange was supported by the unofficial gold movements into India. 8. There was urgent need to usher in a policy to end economic isolation of the country, remove the controlled economic regime, and follow market oriented economic policy to link India with the global economy The package of urgent economic reforms not only to put an end to the above problems facing the country, but could also permanently curbed their further occurrence. This included the following:

The Liberalised Exchange Control Management Scheme A liberal trade policy for both exports and imports Curbing fiscal deficit and government spending and to hold inflation under control

In March 1992 the Government announced the full convertibility of the Rupee in Current Account. A fully convertible rupee provides full freedom to both residents and non-residents to trade in goods, services and assets, thereby to integrate the domestic economy into the world economy. Convertibility on current account along with trade liberalization measures has enhanced the competitiveness of the domestic tradables and has made the world prices to prevail in the domestic economy. The rupee convertibility process has been implemented since July 1991, involving several important elements:

The relaxation of quantitative restrictions on imports by doing away with import quotas and licensing. The reduction of the level and dispersion of import tariff rates The elimination of several export subsidization schemes The liberalization of exchange restrictions on capital flows, particularly the inflow in foreign direct investments and portfolio investments, and Introduction of the market-driven exchange rates of the rupee, instead of the administered system through the mechanism of the basket-peg.

Financial features have registered a significant expansion in recent years with the expansion of the existing futures market in certain centres, particularly London, Singapore and Amsterdam. Interest and currency futures not only offer actual hedging facilities but also speculative opportunities to market participants. The search for banks for alternate non-funding business and also the means to retain valued client relationship led to a spurt of off-balance sheet business, mainly in the form of underwritten new facilities in the initial years and non-underwritten facilities Similarly the quest, for shorter maturity and more liquid assets to counter balance the effectively frozen medium and long term assets in the books of the Banks led to the growth of securitised lending.

29 Growing deregulation in national financial markets and the revolution in telecommunication and data processing technologies resulted in the better integration of financial markets in all countries between the domestic financial system and the foreign Banking and non-banking institutions. The development of new innovative products in the finance and credit market, though useful to transfer risks to counter parties or hedge risks, have also increased the vulnerability of the banks and other financial institutions to the vicissitudes of the market. The problem of declining business opportunities faced by the Banks was further aggravated on account of enormous debt servicing problems faced by a good number of developing countries since 1982. This blocked sizeable assets of major international Banks as Non-productive or nonperforming. Investors reacted by disinvesting in bank equity shares and the Regulatory authorities of Banks responded to the situation by pressing for adequate provisions for bad and nonperforming assets and higher capital adequacy requirements. Thus the most conspicuous change in the International financial market since 1982 has been displacement of direct bank intermediation through the mechanism of syndicated loans, by a wide range of securities lending By instinct the Banks attempted to counteract to the situation by searching for non-funding business. Their efforts to retain valued client relationship led to spurt in their off-balance sheet business, mainly in the form of underwritten new facilities in the initial years and later on to nonunderwritten facilities The quest for shorter maturity and more liquid assets to counterbalance the sizeable fall in the medium and long term credit segment with the Bank, led to the growth of securitised lending. Overall on account of the changes that had taken place in the medium term credit market, several major factors affected the Commercial Banks operating at the International level adversely. These are listed as under: 1. International Debt Problem: The problem faced by developing countries and the burden it loaded on the banks has already been referred. 2. Globalization of International Banking: Globalization has already resulted far reaching changes in the Bank profile of the United States and the Banks in Europe are naturally to follow suit. A number of mergers and other forms of consolidation have transferred capital and power away from major money center banks towards new, efficient and profitable regional and super regional banks. 3. Deregulation: The conservative era prohibiting Banks from venture into any other field other than traditional banking is giving way to a liberalized thinking that banks should be permitted to sell products hither to barred to them like property and insurance. 4. Securitisation ("Maturity transformation"): This concept has already been discussed in detail. 5. Emergency of Japanese Banking: With the Dollar losing ground against major currencies, and the U.S. Banks under severe strain arising mainly out of the debt crisis, it is now the turn of the Japanese Banks to play an increasing role in the international business. This is also supported by the growing current account surplus and the high domestic savings rate of Japan

30 6. The Stock Market Crash: With the stock market crash of 1987, banks have become vulnerable to the decision of depositors regarding the banks. A major concomitant of the above developments in the international financial markets in general and the international banking arena in particular is to dramatically alter the conditions in which banks will have to function. Banks are forced to accept as realities the following

top-notch borrowers with excellent credit ratings are deserting the banks, and The borrowers with excellent credit ratings are tending to fail paying back loans, but also find ways to attract and earn the capital that banks increasingly need.

THE EMERGENCE OF NPA IN INDIAN BANKING & FINANCIAL INSTITUTIONS AND ITS DIMENSIONS

31 Non-performing Asset (NPA) has emerged since over a decade as an alarming threat to the banking industry in our country sending distressing signals on the sustainability and endurability of the affected banks. The positive results of the chain of measures effected under banking reforms by the Government of India and RBI in terms of the two Narasimhan Committee Reports in this contemporary period have been neutralised by the ill effects of this surging threat. Despite various correctional steps administered to solve and end this problem, concrete results are eluding. It is a sweeping and all pervasive virus confronted universally on banking and financial institutions. The severity of the problem is however acutely suffered by Nationalised Banks, followed by the SBI group, and the all India Financial Institutions. NPA statistics is executed through the following ways.

Failure to identify an NPA as per stipulated guidelines: There were instances of `substandard' assets being classified as `standard'; Wrong classification of an NPA: classifying a `loss' asset as a `doubtful' or `sub-standard' asset; classifying a `doubtful' asset as a `sub-standard' asset. Classifying an account of a credit customer as `substandard' and other accounts of the same credit customer as `standard', throwing prudential norms to the winds.

Essentially arising from the wrong classification of NPAs, there was a variation in the level of loan loss provisioning actually held by the bank and the level required to be made. This practice can be logically explained as a desperate attempt on the part of the bankers, whenever adequate current earnings were not available to meet provisioning obligations. Driven to desperation and impelled by the desire not to accept defeat, they have chosen to mislead and claim compliance with the provisioning norms, without actually providing. This only shows that the problem has swelled to graver dimensions. The international rating agency Standard & Poor (S & P) conveys the gloomiest picture, while estimating NPAs of the Indian banking sector between 35% to 70% of its total outstanding credit. Much of this, up to 35% of the total banking assets, as per the rating agency would be accounted as NPA if rescheduling and restructuring of loans to make them good assets in the book are not taken into account. However RBI has contested this dismal assessment. But the fact remains that the infection if left unchecked will eventually lead to what has been forecast by the rating agency. This invests an urgency to tackle this virus as a fire fighting exercise. Emergence of NPA as an Alarming Threat to Nationalised Banks NPA is a brought forward legacy accumulated over the past three decades, when prudent norms of banking were forsaken basking by the halo of security provided by government ownership. It is not wrong to have pursued social goals, but this does not justify relegating banking goals and fiscal discipline to the background. But despite this extravagance the malaise remained invisible to the public eyes due to the practice of not following transparent accounting standards, but keeping the balance sheets opaque. This artificially conveyed picture of 'all is well' with PSBs suddenly came to an end when the lid was open with the introduction of the prudential norms of banking in the year 1992-93, bringing total transparency in disclosure norms and 'cleansing' the balance sheets of commercial banks for the first time in the country.

32 Consequently PSBs in the post reform period came to be classified under three categories as

healthy banks (those that are currently showing profits and hold no accumulated losses in their balance sheet) banks showing currently profits, but still continuing to have accumulated losses of prior years carried forward in their balance sheets Banks which are still in the red, i.e. showing losses in the past and in the present.

NPA has affected the profitability, liquidity and competitive functioning of PSBs and finally the psychology of the bankers in respect of their disposition towards credit delivery and credit expansion.

33

34

Chapter III

CONCEPTUAL ANALYSIS

The Indian Banking System

35 Indias banking sector is growing at a fast pace. India has become one of the most preferred banking destinations in the world. The reasons are numerous: the economy is growing at a rate of 8%, Bank credit is growing at 30% per annum and there is an ever-expanding middle class of between 250 and 300 million people (larger than the population of the US) in need of financial services. All this enables double-digit returns on most asset classes which is not so in a majority of other countries. Foreign banks in India achieving a return on assets (ROA) of 3%, their keen interest in expanding their businesses is understandable even more so when compared with the measly 1% average ROA for the Top 1000 banks in the world. Indian markets provide growth opportunities, which are unlikely to be matched by the mature banking markets around the world. Some of the high growth potential areas to be looked at are: the market for consumer finance stands at about 2%-3% of GDP, compared with 25% in some European markets, the real estate market in India is growing at 30% annually and is projected to touch $ 50 billion by 2008, the retail credit is expected to cross Rs 5,70,000 crore by 2010 from the current level of Rs 1,89,000 crore in 2004-05 and huge SME sector which contributes significantly to Indias GDP.

Indian Banking Sector: Strengths and Weaknesses

36

Regulatory Systems (84.21%) (84.2%) Economic Growth Rate (63.15%) Technological Advancement (52.63%) Risk Assessment Systems (47%) Credit Quality (42.1%)

Areas To Be Geared Up For Future Growth *

Diversification of markets beyond big cities

(84.2%)

HR Systems (63.15%) Size of banks (52.63%) High Transaction Costs (47.3%) Banking Infrastructure (42%) Labour Inflexibilities (42%)

Indian Banking Sector

Turnaround success strategies

Strategies To Be Adopted For Creating World Class Banking System Consolidation Strict Corporate Governance Norms Regional Expansion (Both within India as well as Outside) Higher FDI limits FTA with countries where India has comparative advantage in banking sector

37 Some of the areas that need to be geared up for future growth, identified by the survey respondents were Diversification of markets beyond big cities (84.2%), HR Systems (63.15%), Size of banks (52.63%), High Transaction Costs (47.3%), Banking Infrastructure (42%) and Labour Inflexibilities (42%). Availability and reach of quality products is confined to just big cities. Thus it is essential now to expand the gamut of banking services both within India as well as outside. Size of the banks is also a critical element in the chase for avenues for growth as it facilitates banks to attain new capabilities, technologies and products at lower operating costs. INDIAS STEP TOWARDS GLOBAL COMPETIVENESS Of the many Asia Pacific countries, China, Taiwan, South Korea and India will continue to influence the development of the Asian markets. China and India are one of the fastest growing economies in the world as evident from the graphs below.
Real GDP Growth Rate
%

12 10 8 6 4 2 0
hi

10.5 8.3 7.5 5.6 5.5 5.3 5.1 4.5 4

na

or ea

nd ai la Ta

re

on

di

po

si

ay

ne

In

ga

do

al

on

Si n

In

Th

Source: Morgan Stanley Research

iw

an

si

38

Loan Growth
% 30 25 20 15 10 5 0
na a g or ea on di si nd an iw ay In K po ga Si n hi la re a

27.6

13.4 9.9 8.1 7.7 6.4 6.4 5.1

Ta

al

on

These above-mentioned countries, though at different stages of development, have the potential to become major growth markets for traditional banking, investment banking, insurance, and securities products. As a result, leading international and regional banks are interested to establish their presence in these countries. The Indian banking sector has scored over its counterparts not only in developing but even in developed world such as Japan, Singapore and Australia on significant parameters. According to Moodys Investors Services data, Indian lenders have posted highest ROE of 20.38% (system average of three years), closely followed by Indonesia at 20.19% and New Zealand 18.83%. Japan, the biggest economy in Asia posted negative returns of 6.42%, implying that the banks there made losses. Banks of Phillippines and Australia have posted an ROE of just 4.40% and 11.44% respectively.

Th

ai

Source: Morgan Stanley Research

39

Regulatory Systems of India vis a vis other countries

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

14.29

17.65

17.65 11.76

17.65

78.6 71.43

58.82 35.29

17.65

Better At Par Below Par

52.94 5.89 7.1 14.3 China 14.29 Japan Singapore 29.41 17.65 Russia UK

47.06

USA

Regulatory systems of Indian banks were rated better than China and Russia; at par with Japan and Singapore but less advanced than UK and USA.

Risk Assessment Systems of India vis a vis other countries

100%
21.43 21.43 35.71 14.29 78.57 64.29 14.29 78.57 14.29 21.43

80% 60% 40%

Better At Par
64.29 64.29

Below Par

50

20% 0%

21.42
China

14.29
Japan Singapore

21.43
Russia UK USA

40 Risk management framework is a key strength for sustainable growth of banks. How have we performed in this area? Respondents rated Indias Risk management systems more advanced than China and Russia; at par with Japan, and less advanced than Singapore, UK and USA. This shows we need to work out this but we are not too far. It is with this confidence we are going ahead with the challenge of implementing Basel II by April 2007. 83% of our respondents highlighted that Basel II implementation would take us a step ahead in global competitiveness. Technological Systems of India vis a vis other countries
100% 80% 60% 40% 20% 0% 23 42.9 23
China Japan Singapore

14.29 54 42.9

21.43 14.29 42.86

21.43 7.14

21.43
Better At Par

64.29

35.71

71.43

78.57

Below Par

21.43
Russia UK USA

Technology has given birth to a new era in banking. Technology can be the key differentiator between two banks and a major factor to attain competitive edge. Though slow in the beginning, Indian banks seem to have paced up in adoption of advanced technology, as is evident from our survey results. Technological systems of Indian banks have rated more advanced than China and Russia; at par with Japan, but less advanced than Singapore, UK and USA.

41

Credit Quality of India vis a vis other countries

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

21.43 42.86 57.14 78.57 50 14.28 28.57 28.57 14.29 14.29

Russia UK

35.71
Better At Par Below Par

71.43

57.14

64.29

21.43
China

Japan

Singapore

USA

While enhancement of credit is an important function of the Banks, it is equally imperative to keep a check on the quality of credit to ensure good health of the banking system and effective functioning of market for distressed assets.

One of the key fundamentals of Indian banking sector Credit Quality too has been rated fairly well in comparison with other countries. Majority of respondents quoted credit quality of Indian banks better in comparison with China, Japan and Russia; at par with Singapore but below par with UK and USA. As a percentage of GDP, the Net NPA of Indian banks stands mere to just 1.4% as on March 2006 as compared with 3.1% in 2004-05. As a percentage of GDP, gross NPA in India is just 1.9 % compared with 6.7% in China as on March 2005. It is evident that India fares well on these critical parameters. But are the existing International banks happy doing business here? Well, our foreign bank respondents seem to be happy here and wish to expand further. 75 per cent of the foreign banks respondents rated their working experience in India as extremely good. Given Indias potential over the next decade and beyond, all the foreign banks respondents stated that they have formulated strategies for future expansion in India.

42 The fundamental business of lending has brought trouble to individual banks and entire banking system. It is, therefore, imperative that the banks are adequate systems for credit assessment of individual projects and evaluating risk associated therewith as well as the industry as a whole. Generally, Banks in India evaluate a proposal through the traditional tools of project financing, computing maximum permissible limits, assessing management capabilities and prescribing a ceiling for an industry exposure. As banks move in to a new high powered world of financial operations and trading, with new risks, the need is felt for more sophisticated and versatile instruments for risk assessment, monitoring and controlling risk exposures. It is, therefore, time that banks managements equip them fully to grapple with the demands of creating tools and systems capable of assessing, monitoring and controlling risk exposures in a more scientific manner. THE PROBLEM OF NON-PERFORMING ASSETS Liberlization and Globalization ushered in by the government in the early 90s have thrown open many challenges to the Indian financial sector. Banks, amongst other things, were set on a path to align their accounting standards with the International standards and by global players. They had to have a fresh look into their balance sheet and analyze them critically in the light of the prudential norms of income recognition and provisioning that were stipulated by the regulator, based on Narasimhan Committee recommendations. Loans and Advances as assets of the bank play an important part in gross earnings and net profits of banks. The share of advances in the total assets of the banks forms more than 60 percent7 and as such it is the backbone of banking structure. Bank lending is very crucial for it make possible the financing of agricultural, industrial and commercial activities of the country. The strength and soundness of the banking system primarily depends upon health of the advances. In other words, improvement in assets quality is fundamental to strengthening working of banks and improving their financial viability. Most domestic public sector banks in the country are expected to completely wipeout their outstanding NPAs between 2006 and 2008. NPAs are an inevitable burden on the banking industry. Hence the success of a bank depends upon methods of managing NPAs and keeping them within tolerance level, of late, several institutional mechanisms have been developed in India to deal with NPAs and there has also been tightening of legal provisions. Perhaps more importantly, effective management of NPAs requires an appropriate internal check and balances system in a bank. In this background, this chapter is designed to give an outline of trends in NPAs in Indian banking industry vis--vis other countries and highlight the importance of NPAs management. NPA is an advance where payment of interest or repayment of installment of principal (in case of Term loans) or both remains unpaid for a period of 90 days10

43 The issue of Non-Performing Assets (NPAs) in the financial sector has been an area of concern for all economies and reduction in NPAs has become synonymous to functional efficiency of financial intermediaries. From the early nineties till date, the regulators in India, under the general recommendations of the Narasimhan Committee Reports (1 & 2), Verma Committee Report, Basle 1 & 2 and insights and findings of scholars, have continuously provided guidelines and directives addressed at reducing NPAs. A perusal of the Reserve Bank of India (RBI) circulars in this regard will give the reader a comprehensive idea about the extent of detail in which norms and guidelines have been formulated to arrest the growth in NPAs. It started off with introduction of prudential norms and has delved into adoption of a risk based management system. The Indian financial sector has responded well and adopted the directives given, and the overall health has shown considerable improvement. Although NPAs are a balance sheet issue of individual banks and financial institutions, it has wider macroeconomic implications and the literature, while discussing financial sector reforms, has gone into a discussion on NPAs also. The reasons can be observed from the following flow diagram.

44 Presence of NPAs indicates asset quality of the balance sheet and hence future income generating prospects. This also requires provisioning which has implications with respect to capital adequacy. Declining capital adequacy adversely affects shareholder value and restricts the ability of the bank/institution to access the capital market for additional equity to enhance capital adequacy. If this happens for a large number of financial intermediaries, then, given that there are large inter bank transactions, there could be a domino kind of effect. Low capital adequacy will also severely affect the growth prospects of banks and institutions. With weak growth outlook and low functional efficiency, the sector as a whole will not be able to perform its role and will adversely affect the savings investment process. Once we realize this, it is evident that a micro problem of a bank translates into a macro problem. With weak growth outlook and low functional efficiency, the sector as a whole will not be able to perform its role and will adversely affect the savings investment process. Once we realize this, it is evident that a micro problem of a bank translates into a macro problem of the economy. Capital market development takes a back seat and GDP growth rate weakens. The adverse effects of fiscal deficit loom large and a balance of payments crisis also cannot be ruled out. Banking crisis and foreign exchange crisis get interlinked. REASONS FOR AN ASSET TURNING NPA The various reasons, either singly or jointly, behind an asset turning NPA can be classified as follows 1 Reasons from the economy side 2 Reasons from the industry side 3 Reasons from the borrowers side 4 Reasons from the banking system side 5 Reasons from the loan structuring side 6 Reasons from the security side collateral vs cash flow 7 Reasons from the regulatory side From the above, it may be surprising to many that only the borrower is not always at fault. At times, systemic faults can also adversely affect the profitability of financial intermediaries. The following discussion will clarify our position. 1 2 Reasons from the economy side

0 Political mindset regarding paradigm, proactive, fiscally responsible (national income accounts) 1 b. Economic growth, distribution, efficient allocation of resources 2 c. Social acceptability, mobility, education 3 d. Technological advances in use of IT 4 e. Legal Enforceability of loan contracts 5 f. Environmental liberalization & globalisation

45 If loan contracts are not easily enforceable, there will naturally be a tendency to default. Opening up of the economy can render companies uncompetitive. Lack of adaptation of IT will make data processing difficult and information dissemination will be impossible. Objective analysis of risk would be difficult and appraisal would remain a subjective matter. Similarly, directed programs of lending can be counterproductive. 1 2 1 2 3 4 3 4 5 6 7 8 9 10 11 12 Reasons from the industry side a. Global competition b. Cyclical downswing c. Sunset industry d. Frequent changes in regulatory norms Reasons from the borrowers side a. Misconceived project b. Poor governance c. Product failure d. Inefficient management e. Diversion of funds f. Dormant capital market g. Regulatory changes Reasons from the banking system side

13 1 a. Parameters set for their functioning were deficient: incorrect goal perception and identification lazy banking 2 b. Directed banking and lack of freedom to choose products and pricing 3 c. Being unexposed to international marketing methods and products, people lacked training and knowledge resources 4 d. Ownership and management were not distinguished composition of Board of Directors 5 e. Lack of systems and procedures audit and inspections 6 f. Banks lacked the ability to handle enormous growth in liabilities and assets 7 g. Lack of a mechanism of credit information dissemination 8 h. Lack of an effective judicial system for recovery from defaulters 9 i. Collateral based lending leading to idle assets 10 j. Fixing of price and quantum of loans 11 k. Lack of an effective IT system and MIS 12 14 Reasons from the loan structuring side 15 1 a. High debt equity ratio 1 b. Timing of raising equity 2 c. Discrepancy between the rate of interest charged and the realistic rate of return 3 d. Inconsistency between revenue generation and the loan repayment schedule 4 e. Lack of binding penal clauses and performance guarantees 5 Reasons from the security side collateral vs cash flow

46 6 There is a tendency among banks and institutions to depend excessively on collateral for advancing of loans. While this is important, it presumes from the very beginning that the borrower would default and the security would need to be encashed for recovery of the loan. Clearly, this logic is unacceptable. Emphasis should then be on cash generation and a charge on this should be built into the loan contract through some escrow mechanism. 1 Reasons from the regulatory side

Frequent regulatory changes can turn assets non-performing. Accounting reason like reduction in income recognition norms from 180 days to 90 days could be one such reason. Pollution related issues could be the other reason. Distance between two sugar mills could be a third. 3. Recovery Strategies The various resolution strategies for recovery from NPAs include financial restructuring, change in management, one time settlement, merger, sale to an asset reconstruction Company, securitisation of receivables and filing of legal suit. Under each option there are options, which can be exercised either singly or jointly. The details under each strategy are given in the following. 2

TRENDS IN NPA LEVELS:

Capital to Risk-weighted Assets Ratio (CRAR)
The capital to risk weighted assets ratio (CRAR) is an indicator for assessing soundness and solvency of banks. Out of 92 scheduled commercial banks, 75 banks could maintain the CRAR of more than 8 per cent during the year 1995-96, when the prescribed CRAR was 8 per cent. During 1999-2000, 96 banks maintained CRAR of 9 to 10 per cent and above when the prescribed rate was 9 per cent. In 2004-05, out of 88 scheduled commercial banks, 78 banks could maintain CRAR of above 10 per cent and 8 banks between 9 and 10 per cent. All banks in the State Bank group maintained capital to risk weighted assets ratio of more than 10 per cent in 2004-05. In the nationalised bank group, 17 banks reached more than 10 per cent CRAR level except two banks whos CRAR during 2004-05 was between 9-10 per cent. During 2004-05, there were 2 banks in the old private sector category whose CRAR was less than 9 per cent

47

The measure of non-performing assets helps us to assess the efficiency in allocation of resources made by banks to productive sectors. The problem of NPAs arise either due to bad management by banks or due to external factors like unanticipated shocks, business cycle and natural calamities (Caprio and Klingebiel, 1996). Several studies have underscored the role of banks lending policy and terms of credit, which include cost, maturity and collateral in influencing the movement of non-performing assets of banks (Reddy, 2004, Mohan 2003, 2004). The ratio of gross non-performing assets (NPAs) to gross advances of all scheduled commercial banks decreased from 14.4 per cent in 1998 to 5.1 per cent in 2005. Bank group-wise analysis shows that across the bank groups there has been a significant reduction in the gross nonperforming assets. With respect to public sector banks (State Bank group and nationalised bank group together), NPAs have decreased from 16.0 per cent in 1998 to 5.4 per cent in 2005. In the case of foreign banks group, gross NPAs as a percentage to gross advances, which was the lowest among all the groups at 6.4 per cent in 1998, decreased to 2.9 per cent in 2005. With regard to domestic private sector banks group, gross NPAs decreased from 8.7 per cent to 3.9 per cent during the same period. The ratio of net NPAs to net advances of different bank groups also exhibited similar declining trends during the period from 1998 to 2005. The net NPAs of all scheduled commercial banks declined from 7.3 per cent in 1998 to 2.0 per cent in 2005 The decline in NPAs is more evidenced across bank groups especially since 2003. This reflects on the positive impact of the measures taken by the Reserve Bank towards NPA reduction and

48 specifically due to the enactment of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, ensuring speedier recovery without intervention of courts or tribunal. The composition of NPAs of public sector banks brings to light certain interesting aspects. It is observed that in 1995 for State Bank group, the share of NPAs was 52.5 per cent for the priority sector, 41.4 per cent for the non-priority sector, and 6.1 per cent for the public sector. These percentages were 47.4 per cent, 51.5 per cent and 1.1 per cent, respectively in 2005. Similarly in the case of nationalised banks also, the NPA composition for non-priority sector has increased, whereas, that for priority sector and public sector, there is a marginal reduction. This shows that not only advances to the priority sector are going non-performing, but more than that, nonpriority sector lending is the area where the bankers need to cautiously examine the possibilities of loans becoming non-performing. Here the question of moral hazard, adverse selection and credit rationing comes to the fore. These issues are to be addressed face on. This also goes to explode the commonly held myth that the problem of NPAs is caused mainly due to the credit allocation to priority sectors. An analysis of NPAs of different banks groups indicates, the public sector banks hold larger share of NPAs during the year 1993-94 and gradually decreased to 9.36 percent in the year 2003. On the contrary, the private sector banks show fluctuating trend with starting at 6.23 percent in the year 1994-95 rising upto 10.44 percent in year 1998 and decreased to 8.08 percent in the year 2002-03. NPAs of Scheduled Commercial Banks

COMPOSITION OF NPAS OF PUBLIC SECTOR BANKS

49

Across the bank groups, there has been a significant reduction in the non-performing assets (NPAs). The composition of NPAs of public sector banks interestingly reveals that NPAs connected to nonpriority sector has increased, whereas, NPAs relating to priority sector advances exhibited a decline. This goes to explode the commonly held myth that the problem of NPAs is caused mainly due to the credit allocation made to priority sectors. The share of non-interest income in the total income has been increasing across the different bank groups.

COMPARISON OF NPAs IN YEAR 2005 & 2006

50

51

52

53

CHAPTER IV

FINDINGS & CONCLUSIONS

54

FINDINGS
IMPACT ON PROFITABILITY

The enormous provisioning of NPA together with the holding cost of such non-productive assets over the years has acted as a severe drain on the profitability of the PSBs. In turn PSBs are seen as poor performers and unable to approach the market for raising additional capital. Equity issues of nationalised banks that have already tapped the market are now quoted at a discount in the secondary market. Other banks hesitate to approach the market to raise new issues. This has alternatively forced PSBs to borrow heavily from the debt market to build Tier II Capital to meet capital adequacy norms putting severe pressure on their profit margins, else they are to seek the bounty of the Central Government for repeated Recapitalisation. NPA is not merely non-remunerative. It is also cost absorbing and profit eroding. In the context of severe competition in the banking industry, the weak banks are at disadvantage for leveraging the rate of interest in the deregulated market and securing remunerative business growth. The options for these banks are lost. "The spread is the bread for the banks". This is the margin between the cost of resources employed and the return therefrom. In other words it is gap between the return on funds deployed(Interest earned on credit and investments) and cost of funds employed(Interest paid on deposits). When the interest rates were directed by RBI, as heretofore, there was no option for banks. But today in the deregulated market the banks decide their lending rates and borrowing rates. In the competitive money and capital Markets, inability to offer competitive market rates adds to the disadvantage of marketing and building new business. In the face of the deregulated banking industry, an ideal competitive working is reached, when the banks are able to earn adequate amount of non-interest income to cover their entire operating expenses i.e. a positive burden. In that event the spread factor i.e. the difference between the gross interest income and interest cost will constitute its operating profits. Theoretically even if the bank keeps 0% spread, it will still break even in terms of operating profit and not return an operating loss. The net profit is the amount of the operating profit minus the amount of provisions to be made including for taxation. On account of the burden of heavy NPA, many nationalised banks have little option and they are unable to lower lending rates competitively, as a wider spread is necessitated to cover cost of NPA in the face of lower income from off balance sheet business yielding non-interest income. Impact of NPAs on Development Financial Institutions Health:

The efficiency of any Development Financial Institutions is not always reflected only by the size of its balance sheet but by the level of return on its assets. NPAs do not generate any income for DFIs but at the same time DFIs are required to make provisions for such NPAs from their current profits. Following are the deleterious effect on the return on assets in several ways: 1 They erode current profits through provisioning requirements 2 They result in reduced interest income

55 3 They require high provisioning requirements affecting profits 4 They limit recycling of funds, set in asset- liability mismatches, etc. THE FOLLOWING ARE THE PRIMARY CAUSES FOR TURNING THE ACCOUNTS INTO NPA: 1. Diversion of funds, mostly for the expansion/ diversification of business or for promoting associate concern. 2. Factors internal to business like product/ marketing failure, inefficient management, inappropriate technology, labour unrest 3. Changes in the Macro-environment like recession in the economy, infrastructural bottlenecks etc. 4. Inadequate control/ supervision, leading to time/cost over-runs during project Implementation. 5. Changes in Government policies e.g. Import duties. 6. Deficiencies like delay in the release of limits/ funds by banks/FIs 7. Willful defaults, siphoning of funds, frauds, misappropriation, promoters/ managements disputes, etc. SECONDARY CAUSES ARE AS FOLLOWS: 1. Selection of the project. 2. Implementation of the project- time over-run, cost over-run, under-financing technology involved 3. Intention of the borrower. 4. Industrial/ Economic trend. 5. Absence of the up gradation of the unit/ ploughing back of the profit.

DIFFICULTIES WITH THE NON-PERFORMING ASSETS:

1. Owners do not receive a market return on their capital. In the worst case, if the bank fails, owners lose their assets. In modern times, this may affect a broad pool of shareholders. 2. Depositors do not receive a market return on savings. In the worst case if the bank fails, depositors lose their assets or uninsured balance. Banks also redistribute losses to other borrowers by charging higher interest rates. Lower deposit rates and higher lending rates repress savings and financial markets, which hampers economic growth. 3. Non performing loans epitomize bad investment. They misallocate credit from good projects, which do not receive funding, to failed projects. Bad investment ends up in misallocation of capital and, by extension, labour and natural resources. The economy performs below its production potential.

56 4. Non performing loans may spill over the banking system and contract the money stock, which may lead to economic contraction. This spillover effect can channelize through illiquidity or bank insolvency; (a) when many borrowers fail to pay interest, banks may experience liquidity shortages. These shortages can jam payments across the country, (b) illiquidity constraints bank in paying depositors e.g. cashing their paychecks. Banking panic follows. A run on banks by depositors as part of the national money stock become inoperative. The money stock contracts and economic contraction follows (c) undercapitalized banks exceeds the banks capital base. Lending by banks has been highly politicized. It is common knowledge that loans are given to various industrial houses not on commercial considerations and viability of project but on political considerations; some politician would ask the bank to extend the loan to a particular corporate and the bank would oblige. In normal circumstances banks, before extending any loan, would make a thorough study of the actual need of the party concerned, the prospects of the business in which it is engaged, its track record, the quality of management and so on. Since this is not looked into, many of the loans become NPAs. The loans for the weaker sections of the society and the waiving of the loans to farmers are another dimension of the politicization of bank lending. Most of the depositors money has been frittered away by the banks at the instance of politicians, while the same depositors are being made to pay through taxes to cover the losses of the bank.

KEY STRUCTURAL CHANGES Phasing out of statutory pre-emption - The SLR requirement have been brought down from 38.5% to 25% and CRR requirement from 7.50% to 5.75%. (Presently 4.5%) Deregulation of interest rates - All lending rates except for lending to small borrowers and a part of export finance has been de-regulated. Interest on all deposits is determined by banks except on savings deposits. Capital adequacy - CAR of 9 % prescribed with effect from March 31, 2000. Other prudential norms - Income recognition, asset classification and provisioning norms has been made applicable. The provisioning norms are more prudent, objective, transparent, and uniform and designed to avoid subjectivity. Entry of new private sector banks - 9 new private sector banks have been set up with a view to induce greater competition and for improving operational efficiency of the banking system. Competition has been introduced in a controlled manner and today we have nine new private sector banks and 36 foreign banks in India competing with the public sector banks both in retail and corporate banking

57 Functional autonomy - The minimum prescribed Government equity was brought to 51%. Nine nationalised banks raised Rs.2855 crores from the market during 1994-2001. Banks Boards have been given more powers in operational matters such as rationalization of branches, credit delivery and recruitment of staff Debt Recovery Tribunals - 22 DRTs and 5 DRATs have already been set up and 7 more DRTs will be set up during the current financial year. Comprehensive amendment in the Act have been made to make the provisions for adjudication, enforcement and recovery more effective. Transparency in financial statements - Banks have been advised to disclose certain key parameters such as CAR, percentage of NPAs, provisions for NPAs, net value of investment, Return on Assets, profit per employee and interest income as percentage to working funds.

PROVISIONING NORMS In conformity with the prudential norms, provisions should be made on the non-performing assets on the basis of classification of assets into prescribed categories as detailed earlier. Taking into account the time lag between an account becoming doubtful of recovery, its recognition as such, the realisation of the security and the erosion over time in the value of security charged to the bank, the banks should make provision against loss assets, doubtful assets and substandard assets as below:

REPORTING FORMAT FOR NPAs

58

CONCLUSION

59

Asset quality is one of the important parameters based on which the performance of a bank is assessed by the regulation and the public. Some of the areas where the Indian banks identified to for better NPA management like credit risk management, special investigative audit, negotiated settlement, internal checks & systems for early indication of NPAs etc The response to Basel Accord II reforms world over is not uniform and spontaneous. Basel-II is known for complicated risk management models and complex data requirements. Big international banks, as those in the US, prefer this new version, as they perceive that their superior technology and systems would make them Basel compliant and provide an edge in the competitive environment, in the form of lower regulatory capital. Indian banks do not perceive any immediate value in the new norms as they are globally insignificant players with simple and straight forward balance-sheet structures. This is clearly vindicated by the sample study according to which 57 per cent of the executives of public sector banks are sceptical about Basel Accord II norms, particularly in respect of investment cost and the complexity of proposed internal rating system. As against this, the private sector banks with supposedly more investment in technology related infrastructure are in favour of the proposals under New Basel Capital Accord as vindicated by the sample study according to which 67 percent of executives of private sector banks are in-favour for New Basel Capital Accord. However, putting Basel II in place is going to be far more challenging than Basel I. The adoption of Basel II will boost good Risk Management practices and good corporate governance in banks. However, the cost of putting in place robust system today is viewed in an increasingly number of countries as a price worth paying to prevent such crisis. Assuming that the banks can get over the technological and operational hurdles, switching over to Basel II norms can no doubt turn the Indian banks, mainly the public sector banks, more efficient and competitive globally. This, in turn, will help strengthen the financial sector to undertake further reforms including capital account convertibility more confidently. It is realized that if a resolution strategy for recovery of dues from NPAs is not put in place quickly and efficiently, these assets would deteriorate in value over time and little value would be realized at the end, except may be its scrap value. That is why; asset securitisation has gained popularity among financial sector players. The literature, however, has not specifically discussed about the various resolution strategies that could be put in place for recovery from NPAs, and in particular, in which situation which strategy should be adopted. The purpose of this paper is to indicate the various considerations that one has to bear in mind before zeroing on a resolution strategy. The details of the strategy would follow after that. It is important to note that it is difficult to get data from banks and institutions regarding the decision process that leads to a specific resolution strategy for a particular NPA. This is so as there is no fixed formula on the basis of which a recovery strategy for a NPA is undertaken. Broad parametric guidelines can be given like vintage of plant and machinery and current market value, future revenue generating potential of the assets, extent of provisioning in the books of the lender, asset classification as per prudential norms, the nature of the industry etc. But to arrive a specific figure for a one time settlement or sale of a second hand asset or financial restructuring involves

60 subjective elements in bargaining, the extent to which the borrower is conscious of his/her social status, financial strength of the incumbent promoter etc. For example it is difficult to substantiate as to why a bank, for a particular company, went it for settlement for 50% of the principal amount waiving all other dues. Two NPAs of the same vintage in the same industry may be resolved in two ways. This is why, although Reserve Bank of India (RBI) has given some guidelines in this regard, it has left it to the discretion of the Board of Directors of a bank/institution to take decisions outside the guidelines of RBI.

61

CHAPETR V RECOMMENDATIONS & REFERENCES

62

RECOMMENDATIONS
The various resolution strategies for recovery from NPAs include financial restructuring, change in management, one time settlement, merger, sale to an asset reconstruction company, securitisation of receivables and filing of legal suit. Under each option there are options, which can be exercised either singly or jointly. The details under each strategy are given in the following. 1 2 Early recognition of the problem Early Alert System determine threshold for proactive intervention before account becomes a NPA Identify borrowers with genuine intent Restructuring should be attempted only after an objective assessment of the viability and the promoters intent. Banks should be convinced of a turnaround within a scheduled timeframe Timeliness and adequacy of response Focus on Cash flows Management Effectiveness Consortium / Multiple Financing

FINANCIAL RESTRUCTURING

0 Reschedulement of the principal repayment 1 Reduction in the rate of interest 2 Funding of past due interest into loan or instruments (debt or equity or quasi equity) 3 Funding of future interest 4 Waiver of past simple interest, compound interest or liquidated damages 5 Conversion of loan into equity or quasi-equity 6 Reduction in equity 7 Debt write-off 8 Funds infusion by way of equity or debt for project completion 9 Funds infusion for working capital purposes 10 Escrowing of receivables Trust & Retention Account Under this strategy, the company is in operation, but requires some relief. However, along with reliefs, some additional fund infusion by the promoter should be a must. B. CHANGE IN MANAGEMENT 1 2 1 2 Change in the promoters Induction of professionals ONE TIME SETTLEMENT (OTS) 3 Full principal with all past interest and future interest with prepayment premium

63 4 5 6 7 Full principal with all past interest Full principal with part interest Full principal with full or part interest converted to equity or quasi equity instrument Part principal with the remaining part converted to some equity or quasi equity instrument Part principal and remaining part written off

8 9 10 D. MERGER WITH ANOTHER COMPANY 11 12 13 14 15 16 17

Nature of the industry sunrise or sunset Synergy issues Valuation Share swap ratio Tax implications

64

CHART FOR ASSESSING CORRECTIVE STEPS IN DIFFERENT CIRCUMSTANCES:

65

REFERENCE:
Non-Performing Loans and Terms of Credit of Public Sector Banks in India: An Empirical Assessment, Reserve Bank of India Occasional Papers, Personal website of R Kannan K Raghavan, Manager, Bank of Baroda Maximising Value of NPAs, World Bank A study of NPAs in India, Prashanth K Reddy www.geocities.com/kstability/content/index.html www.rbi.org.in